James Moore: A worthy attempt by the FSA to lead the way on banking reform

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The Independent Online

Outlook The more we learn about the banking crisis, the more crazy what was going on in the months leading up to it appears to be. Take credit derivatives, those weird and wonderful devices that, when linked to subprime mortgages, very effectively spread a worldwide financial 'flu.

There was a huge leap in the trading of these things in the months leading up to the crunch because the rules at the time meant that banks had to hold far less capital against "traded debt" when compared with "real debt". Naturally, some clever bankers took note of this, calculated the effect on their bonuses and woosh, the market took off. With devastating results.

Yesterday the FSA quietly put forward a discussion paper suggesting measures that regulators might like to think about taking to prevent a repeat. Some of its suggestions we've heard before, under one guise or another, such as a call for improvements to risk controls. But within the admittedly rather dense text lurk a few good ideas. The most important suggestion concerns capital. It's true that the amount banks have been ordered to hold has increased by a factor of three, which means more padding in the event of future shocks. But telling banks to hold capital is all very well. Problems can easily arise if you frame the rules about what you have to hold capital against (and how much you have to hold) badly.

Under the framework that operated before the crunch, banks were clearly incentivised by the then capital requirements to hold lots of traded debt. Taking advantage of incentives like this was perfectly logical for individual banks. Indeed, you might even argue that their directors would be under a duty to their shareholders to do just that. The trouble is, as we know now, the net effect of lots of banks shuffling derivatives linked to debt back and forth with precious little capital behind it was the creation of a firestorm.

Another suggestion is the creation of a uniform method for the way trades are reported, in the hopes that this will make it easier to see who has been doing what.

As ever, with banks, creating new rules that improve things is easier said than done. If you set a regulation, you'll eventually find a clever banker who either finds a way around it, or discovers a way to exploit it. The other difficulty with getting the FSA's suggestions to work in practice is that it freely admits that they will have to be adopted internationally, or at least by the major financial centres. And, as is depressingly clear, banks are very adept at cynically playing these centres off against each other.

It is to be hoped that the prospect of a repeat of the crisis concentrates minds. But, as has been seen with the arguments at the G20 over banking levies, the backsliding has already begun. All the same, the FSA's attempt to lead the way on reforms is a worthy one. The watchdog has started to talk sense. Just as George Osborne prepares to rip it to bits.